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Competitive and Well-Governed State Banks that Serve Everyone – A Prerequisite for Stronger Growth in Ukraine

Banks, especially private commercial banks, have played a crucial role in Ukraine’s economic development. By the end of its first year of independence, the country had around 90 registered banks. By the middle of the 1990s, the number of banking licenses peaked at 220, before falling back to around 180 in 2014, as the crisis that unfolded over the next two years started to take hold.

Over the past two decades, Ukrainians have become comfortable dealing with banks—withdrawing cash from ATMs, banking online, and sending money electronically. As nearly everywhere else in the world, banking has become part of everyday life for Ukrainians.

It is because banks became so ubiquitous in Ukraine’s economy that the deep faults in the system played such an out-sized role in the crisis years of 2014 and 2015, during which the economy contracted by a cumulative 16 percent. The carnage in the banking sector was severe. More than 90 banks—half the system—failed since 2014, including the largest bank in the country—Privatbank—which had to be nationalized.

As in the US financial crisis of 2008, the Ukraine economic crisis of 2014 was in large part a financial crisis triggered by deep rooted problems accumulated in banking system, particularly the history of related party lending and poor banking supervision. To put it simply, too many local private banks were captive institutions, taking deposits from Ukrainian citizens and lending to a handful of companies and persons related to bank owners.

Ukraine is hardly alone in experiencing serious distortions in the allocation of resources by the banking sector. These events have been all too familiar in recent years. What has stood out in Ukraine is the growing participation of state-owned banks during the last ten years.

Typically, state-owned financial institutions have a carefully circumscribed, temporary mandate to address existing market failures; to expand counter-cyclical credit when financing is scarce, provide financing to targeted SME clients which are not yet served by private banks and foster financial inclusion. To date, this has not been the role of state-owned banks in Ukraine. Nevertheless, their prevalence in the sector has exploded.

In 2008, the share of state-owned banks in total banking assets was 11 percent. By 2013 it had grown to 18 percent, but still roughly in line with the overall share of the public sector’s role in GDP at just over 10 percent. Today, domestic state-owned banks control more than 50 percent of total banking assets, while the share of the state in total GDP remains essentially unchanged. This is dangerously out of balance.

More important than the size of the state-owned financial sector is how it is governed, and the potential threat it poses to the economy. Indeed, when financial crises develop, what determines their severity and the pace of recovery is the quality of the financial regulatory system and the quality of corporate governance.

The Ukrainian National Bank has made great strides in cleaning up the country’s banking sector in recent years. Determined action by the authorities has significantly improved the sector’s regulatory framework.

However, despite these achievements, the governance structure of state-owned banks—including the role of politicians in the appointment of supervisory boards—remains largely intact. Unsurprisingly, this has led to political influence and abuse of banks by vested interests. It has also led to massive losses: during 2009-2016, the two banks that were initially established as state banks (Oshchadbank and UkrEximBank) received UAH61.8 billion in new capital and generated a cumulative net loss of UAH 41.3 billion.

Equally predictable, politically motivated lending has also led to a deterioration of credit risk analysis. The level of non-performing loans in the same banks, Oshchadbank and UkrEximBank, are 64 and 65 percent, respectively; as opposed to 43 percent for the privately-owned part of the banking system. The bottom line is that Ukrainians are paying a high price instead of benefiting from their state-owned banks.

Action is needed on two fronts to ensure state-owned banks serve everyone.

First, to ensure sustainable development of the banking sector and safeguard its engagement in healthy financial intermediation, it is necessary to introduce a new governance framework for state-owned banks. Central to this is enhancing the independence of supervisory boards of state-owned banks to minimize political influence on bank operations. This would improve the attractiveness of state-owned banks to potential investors.

Second, the government should decide on the role of each state-owned bank and make public its strategy for the state-owned banking sector. This strategy should lead to a substantial reduction of the state share in the banking system, which can be achieved through privatization. Also, there is a need to develop a toolkit for all banks, including state-owned banks, to deal with distressed assets and to create a secondary market for non-performing assets. That would help banks shed distressed assets from their portfolios and start fueling the growth with new loans.

The World Bank stands ready to help Ukraine build an effective and fair financial system that serves all of society by effectively intermediating funds from many-to-many instead of many-to-few. Governance reform of state-owned banks is one such crucial reform. It requires effort and political compromise, but the ultimate goal of having a modern, competitive financial system that provides resources for the economy to grow is well worth the effort.